Currency Substitution and Monetary Policy Effects: The Case of Latin American Countries

In this study, we empirically investigate how currency substitution transmits foreign monetary policy shocks to domestic countries and evaluate how the central bank respond to real exchange rate movements in three inflation-targeting Latin American countries under currency substitution, namely Chile, Mexico and Peru, between 2000 and 2011. Our model is based on a small open economy dynamic stochastic general equilibrium model that incorporates currency substitution and incomplete financial markets, and we estimate it by using Bayesian estimation techniques. Our empirical results are as follows. First, the degree of currency substitution is higher in Mexico, while it is negligible in Chile and Peru, which reflects the slight differences in the parameter values capturing the preference for the domestic currency among these countries. Second, the estimated coefficients of the real exchange rate gap in the monetary policy rule are high, meaning that the central banks in these countries actively respond to real exchange rate movements to diminish real exchange rate volatility. Third, domestic monetary policy influences the domestic economy through the real interest rate channel. On the contrary, foreign monetary policy has a significant effect in Mexico, while it is insignificant in Chile and Peru. This finding suggests the potential instability of currency substitution in that slight changes in the parameter values capturing the preference for the domestic currency alter the degree of insulation from foreign monetary policy shocks.